Untangling the Chinese bond knot

U.S. Vice President Joe Biden’s trip to Beijing this week was overshadowed by tensions arising from China’s announcement of its air defense identification zone, a wide swath of the East China Sea, which includes territory administered by Japan. But increased Sino-American tension also has profound economic dimensions — perhaps the most important being China’s ownership of U.S. bonds, an arrangement that fundamentally links the two major economies yet could soon be the root of future discord.

In June 2006, before the global financial crisis, China owned only $699 billion in U.S. securities. Back then, they were still a decent investment — returns on U.S. bonds were above 5 percent. Now, however, the returns are essentially zero and the risk is higher, yet China keeps buying more. As of the end of September, China’s foreign exchange reserves stood at $3.66 trillion, with approximately $800 billion more at state banks. Why does China park so much of that money — more than $2 trillion —in U.S. bonds?A lack of alternatives.

But this can’t last forever. So the more important question is when Beijing will seek to climb out of the box it jumped into when its holdings of U.S. bonds began to soar. An even more critical question is just how China will go about divesting. The Communist Party has five options to ease dependence on U.S. bonds. Each is unpleasant.

1.Sell U.S. bonds.

Several times a year, an advisor to the Chinese governmentespouses selling U.S. bonds and buying alternative investments such as assets denominated in other currencies or gold, among others. In an Oct. 15 Financial Times op-ed, for example, Chinese economist Li Daokui suggested Beijing could purchase as much as 5 percent of the shares of multinational companies operating in China and listed on stock exchanges worldwide, as well as up to 5 percent of the shares of public utility companies in mature market economies, and could increase its holdings “of all non-US sovereign bonds rated higher than double A plus.”

This plan has at least two glaring problems. What country wants to sell China hundreds of billions of dollars in bonds, pressuring its currency higher? In 2010, Japan called out China for doing so with far smaller purchases. Chinese outward investment in 2012 hit a record $87.8 billion, but even at that level included multiple large-scale setbacks. Will dozens more major companies step forward to offer China large stakes in their business? The scope for a quick expansion is sharply limited.

Meanwhile, the problem is growing. In the third quarter of 2013 alone, China added $166 billion to official reserves. To reduce the percentage of U.S. bonds in the reserves, the State Administration of Foreign Exchange (SAFE) would have to find a different investment for an additional $100 billion on average every new quarter.

But even before SAFE, the agency that manages China’s foreign exchange reserves, invests this money, it needs to find a buyer for its existing U.S. bond holdings. This will be difficult because Washington is already selling hundreds of billions of dollars in bonds annually to the same buyers China will seek. To make the sales, SAFE will have to offer steep discounts. And it will likely receive mostly U.S. dollars in return — because that is what buyers will want to offload if they are purchasing more U.S. bonds.

2. Open the capital account.

A common misconception concerning Chinese reserves is that the Communist Party can and should spend the money at home. It should — but it cannot. Controls on the movement of capital flowing in and out of the country separate the financial books of all actors, from the central government to households, into domestic and foreign ledgers. This limits domestic Chinese entities’ ability to use dollars, which cannot be used on bills or wages, or be freely sent overseas. Because they have little use, the overwhelming majority of dollars distributed in China would be exchanged for renminbi (RMB), China’s currency, at the only place authorized to conduct foreign exchange — the state banking system. And official reserves would go right back up.

If Beijing lifted capital controls, foreign exchange reserves would have far greater uses domestically. In the Chinese court of public opinion, this is the most palatable option, as it would allow Beijing to more easily spend the money domestically. Talk in 2011 of a Chinese bailout of the European Union foundered quickly, for example, over the reaction at home.

But Beijing is unwilling to allow domestic capital free exit from the country. It appears to fear a nightmarish scenario: Formerly captive deposits pour out, forcing the People’s Bank of China, the central bank, to frantically redeploy reserves to patch state financials. This would undermine, at least temporarily, state control of the financial system. Yes, it seems impossible that enough money could leave to override the benefits of perhaps $2 trillion spent domestically. Nonetheless, this fear has paralyzed the Communist Party since it began seriously considering liberalization after China joined the World Trade Organization in 2001. November’s important Third Plenum meeting offered the same vague promises on capital account opening, but still no timetable. The safe bet is that controls remain.

3. Reverse course on the renminbi.

The huge quarterly increases to China’s foreign reserves are due in part to Beijing’s purchases of foreign currency, especially dollars, on the open market in order to cap the RMB’s value. If the People’s Bank were to let the RMB move unimpeded, China’s accumulation of reserves would slow, perhaps dramatically. While this would make it easier to avoid buying additional U.S. bonds, it would not affect the bonds already held. That would require a full reversal, with the People’s Bank selling foreign currency and buying RMB, drawing down its excess reserves in the process.

In principle, this is entirely reasonable. A more valuable RMB would have massive benefits: It would hedge against rising global energy prices, for example, and provide a major boost to the transition to the consumption-led growth that the Communist Party claims to want. No longer a small country seeking to export its way to growth, China has aspirations to global leadership — and sustained economic leadership requires a strong currency.

But in practice, this is very unlikely. Because the RMB is still pegged to the dollar, movement of the RMB against other currencies is still explained almost entirely by the movement of the dollar. It would be far easier for Beijing to de-peg the RMB and stop accumulating reserves than to try to reallocate current U.S. bond holdings. Yet Beijing has steadfastly refused to do so because it does not want to directly subject the RMB to market forces.

4. Reverse course domestically.

Besides the unpalatable task of strengthening the RMB, Beijing has plenty of other tools for internal restructuring. Cutting subsidies for domestic production, for example, would help, as would reforms aimed at rebalancing consumption and investment.

At the November plenum, Beijing announced steps in this direction; if implemented, they would gradually limit the accumulation of reserves. Unfortunately, the problem is immediate, not long term. As with the exchange rate, stopping further increases in China’s foreign exchange reserves would require transformative reform. And it would still leave current reserves unaffected.

For domestic restructuring to ease dependence on U.S. bonds, it would have to be at the level of the reforms of 1978, when Beijing granted farmers property rights, or 1993, when many state-owned enterprises lost their protected status. In contrast to these previous rounds, led by Chinese leader Deng Xiaoping, President Xi Jinping and his colleagues have not shown the will or the capacity to move so quickly and decisively.

5. Hope for a massive new country to enter the global economy.

Drawing on government holdings of foreign currency, state institutions like China Development Bank have funded development projects around the globe, from dams in Laos to refineries in Latin America. This has barely made a dent in reserves, but it serves as a model.

Few international opportunities are big enough to make it worthwhile for SAFE to sharply reorient its portfolio despite the costs of selling U.S. bonds.Another financial crisis could be an opportunity, depending on how much the afflicted countries would pay for Chinese help. An internationally rehabilitated Iran would have a good deal to offer in return for large-scale Chinese investment.

Size-wise, the preeminent possibility is North Korea. Even peaceful Korean reunification would require hundreds of billions of dollars for imports, fiscal support, and development. South Korea would want help, and China would not want heavy involvement from the United States or Japan. The timing of Korean reunification is unclear, of course, but it would suffice to draw Beijing out of the U.S. bond trap.

Yes, waiting for the unification of North Korea is not an ideal investing strategy, but neither is waiting for U.S.-China tensions to dissipate. Mutually assured economic destruction cannot last forever in a dynamic global marketplace. And Beijing needs to pursue one of these options, soon.